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The Final Volcker Rule: 10 Issues for Banks to Consider

Banking institutions received some hoped-for elements of relief in the final¹ Volcker Rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which was approved and released by U.S. regulators on December 10, 2013. For example, the scope of the market-making exemption is broader than in the notice of proposed rulemaking (NPR),² and the minimum threshold for metrics reporting has increased. In addition, the number of required metrics is reduced, and regulators have provided an extension of the conformance period by one year to July 21, 2015. Foreign banks (and foreign governments) may also be heartened, as the final rule is less restrictive in several ways, including the scope of permissible foreign banks’ non-U.S. activities, and the permissibility—albeit with limitations—of trading in foreign sovereign debt.

Nevertheless, “the impact of the rule could be significant,” says Robert Maxant, managing partner and leader of Deloitte & Touche LLP’s Financial Institution Treasury practice. Some requirements have become more stringent, and the compliance bar overall has been set high. “Institutions with fragmented systems, poor data quality and underdeveloped foundational competencies likely will have a significant amount of work ahead of them,” adds Mr. Maxant.

Following are 10 important operational concerns for banking organizations to consider as they begin to develop and implement compliance programs to meet the final Volcker Rule requirements.

1. Broader interpretation and judgment. The final rule allows for, and in fact requires, greater judgment in an institution’s interpretation of what is permissible versus impermissible in certain areas, such as market-making and hedging. While this change could seem like a positive development for banks, it may also introduce greater compliance risk. For example, institutions may find the application of judgment to be more complex, and incorporating judgment into operations to preclude unintended inconsistency may be a challenge in large organizations where information and decision-making are typically compartmentalized.

2. Risk-mitigating hedging. This exemption permits the hedging of individual and aggregate risk, but complying with the exemption could be complex. The requirements include identification of the risks being hedged, demonstrable reduction or mitigation of the identified risk, contemporaneous documentation and demonstrating correlation both prior to execution and on an ongoing basis. These requirements are analogous to provisions in U.S. Generally Accepted Accounting Principles and International Financial Reporting Standards, and individuals with experience applying such standards understand the challenges involved in industrializing these types of requirements.

3. Reporting metrics. The number of metrics required to be reported by the NPR has been reduced to seven from seventeen. Most notably, the final rule does not require the calculation of “spread profit and loss (P&L).” Additionally, the “inventory risk turnover” has been replaced by a requirement to calculate a simpler “inventory turnover” metric. Nevertheless, the calculation of metrics at institutions is, in some cases, inconsistent across desks and metrics (e.g., risk sensitivity versus comprehensive P&L attribution), and the rule specifies that a larger banking organization “may need to develop other quantitative measurements…to have an effective compliance program.” Institutions with greater than or equal to $50 billion of trading assets and liabilities will need to start reporting metrics by June 30, 2014, while institutions with less than $10 billion of those holdings will not have to report metrics. However, many of the smaller institutions will be required to calculate and monitor required metrics or measures of their own design.

“Even organizations that have made significant progress with respect to metrics calculations based on the NPR requirements would need to revisit the metrics as five out of seven have been modified in some capacity or the other,” says Raj Trehan, a director with Deloitte & Touche LLP. “Institutions that adopted a wait-and-see approach in anticipation of the final rule release and therefore did not progress much with respect to their metrics initiative will need to conduct a thorough assessment of their existing data, processes, infrastructure and resources in order to evaluate their current state of preparation against their target state,” he adds.

4. Book structure and control processes. The book structure aligns with the trading desk concept and underlies the operational basis for applying metrics, distinguishing between risk positions and hedges, and effecting compliance monitoring. “A well-designed book structure with effective related control processes can be critical to efficient and effective compliance, particularly at larger banking organizations,” says Mr. Maxant.

5. Compliance requirements. Generally, banking entities exceeding $10 billion in consolidated assets will be required to implement a program of compliance. The program should be “appropriate for the types, size, scope and complexity of activities” for the banking organization, according to the final rule. At a minimum, the program is required to include: policies; limit setting, monitoring and management; internal controls designed to monitor compliance; independent testing and audit of the effectiveness of the compliance program; and retention of records sufficient to demonstrate five years of compliance.

The enhanced minimum standards for programmatic compliance apply to larger banking entities based on varying thresholds, including U.S. institutions with greater than or equal to $50 billion in total consolidated assets. These requirements are more stringent than the NPR. In addition, the final rule clarifies that institutions will need “ongoing, timely monitoring and review of calculated quantitative metrics” and the establishment of “numerical thresholds” for each trading desk. It also stipulates that they undertake “immediate review and compliance investigation when quantitative measurements or other information suggest a reasonable likelihood” of a trading desk violation. Some large institutions may have hoped to implement compliance monitoring on a monthly basis. However, “a monthly review or monitoring cycle does not appear to be sufficient,” says Edward Hida, a partner and global leader of Risk and Capital Management for Deloitte Touche Tohmatsu Limited’s Global Financial Services Industry practice. “As a result, the operational implications are that institutions may have to build up industrialized Volcker Rule compliance processes that are executed on a daily basis,” Mr. Hida adds.

6. Responsibility and accountability. The enhanced minimum standards for programmatic compliance impose significant responsibility on the board of directors. In addition, senior management is responsible for “implementing and enforcing the compliance program,” and is “responsible for reviewing the compliance program and periodically reporting to the board (or board committee) on compliance matters and program effectiveness.” Further, business line managers are “accountable for the effective implementation and enforcement of the compliance program” for applicable trading desks. Last, the chief executive officer (CEO) of the banking organization must annually attest in writing to its regulator that the institution has in place processes to establish, maintain, enforce, review, test and modify the compliance program. While the standard of CEO certification is less than what many discussed during the NPR process, the responsibility and accountability provisions of the rule are collectively stringent. It is likely that many institutions will implement a regime of sub-certifications to support the CEO certification, as well as board and business line manager accountabilities.

8. Covered funds. All banking organizations are subject to the final rule’s covered-fund provisions regardless of the size of their funds’ activity. The final rule provisions preserve the 3% per fund and tier 1 capital de minimus limits, as well as the Super 23A and Section 23B provisions, which relate to transactions with affiliates. Further, the final rule, similar to the NPR, does not exclude or grandfather pre-existing investments in covered funds or restricted relationships and transactions. “The final fund rules are complex and require a significant level of assessment to understand the impact and response required to comply,” says Matthew Dunn, a director with Deloitte & Touche LLP. “Specifically, the banking business and legal teams should consider working closely to develop a plan to resolve current covered fund activities and investments.”

9. Other than temporary impairments (OTTI). The issuance of the final rule potentially triggers the recognition of OTTI, if there are instances in which underwater investments would now need to be disposed. Collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) and possibly other instruments may be ineligible for the covered fund exclusion. In such circumstances, even if disposition would be required at a later date, the impairment may need to be recognized earlier.

10. Interactions with other regulations. There are interactions between the Volcker Rule and other regulations, including potential impacts related to Basel capital requirements and nexus to the Basel III liquidity coverage ratio standards, Regulation W, proposed enhanced prudential standards for U.S. and foreign institutions and Title VII of the Dodd-Frank Act. The roughly coincident timing of complying with these other requirements, and in certain instances levering common methodologies, processes and systems, suggest that disciplined program management is likely to be a benefit.

The compliance deadline of July 21, 2015, may seem distant. However, except for the smallest banking organizations, a significant amount of work may need to be planned and executed in 2014. Furthermore, 2014 is a year in which many other Dodd-Frank Act requirements will also need to be implemented. “To help organizations work toward the correct timelines and priorities, executives and boards of financial institutions should understand the Volcker Rule requirements and how the rule interacts with other in-flight initiatives,” says Mr. Hida, adding that, “it’s likely the final Volcker Rule will spur a significant amount of work within the business units and functions for many banking institutions.”

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